New on FinoLib · Volume III: Finance Encyclopedia
New on FinoLib, my finance education website: I have published an article called Public-Private Partnerships (PPPs) and Infrastructure Finance, from Volume III: Finance Encyclopedia. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
2.6 Infrastructure Debt and Equity — Who Invests and Why
The idea in plain words
Roads, power lines and pipelines attract pension funds, insurers and sovereign funds, because contracted or regulated assets pay long, predictable cash flows that are often linked to inflation. How bond-like an asset behaves depends on who sets its income: a contract, a regulator or its users. The more the income depends on how many people use it, the more it behaves like a business.
Key points
■A US regulated utility earns revenue = r × rate base + expenses + depreciation + taxes, reset at each rate case.
■With 50% debt, a one-point cut in the allowed return cut equity income by 22% in the worked example.
■Moody’s found a 5.6% ten-year default rate and 77.5% recovery for project finance loans over 1983–2017.
A closer look
Infrastructure assets typically generate long-dated, relatively predictable, often contractually fixed or inflation-linked cash flows (toll revenue, a government-guaranteed power purchase agreement) — a distinct risk-return profile from either pure fixed income or pure equities, as introduced in Capital Markets Part 8. This makes infrastructure debt and equity particularly attractive to institutional investors with very long time horizons and a need to match long-dated liabilities — pension funds, insurers (this Volume’s Part 1: Insurance & Actuarial Finance), and sovereign wealth funds (Capital Markets Part 8) are the dominant capital sources for large infrastructure deals worldwide.
Investors sort infrastructure from core (operating, contracted or regulated) through core-plus to value-add and opportunistic (construction, expansion or market-price risk). Brownfield (operating) assets suit insurers and pension funds matching long liabilities; greenfield assets carry completion risk and pay more.
Decision rule
Before calling an infrastructure asset “bond-like”, ask who sets its revenue. If a contract with a creditworthy counterparty sets it, analyze credit; if a regulator resets it, analyze the reset; if users choose it, analyze it as equity. Then check inflation links: contractual indexing protects directly, while a US original-cost rate base passes inflation through only at the next rate case. Ignore the “core” label if large new capital spending or a contract expiry falls within your holding period.
The costliest mistake
Ignoring how leverage magnifies a regulatory reset. Fund the utility above with $500M of debt at 5% ($25M interest) and $500M of equity, ignoring tax. At a 7% allowed return equity earns ($70M − $25M) ÷ $500M = 9.0%. Cut the allowed return to 6% and revenue falls $10M to $175M; equity earns ($60M − $25M) ÷ $500M = 7.0%, a 22% cut in equity income from one regulatory decision. Model the next rate case, not only the current one.
2.7 Public-Private Partnerships (PPPs)
The idea in plain words
In a public-private partnership, the government hires a private group to design, build, finance and often run public infrastructure for decades. The group is paid by user fees or by availability payments from the government. The government hands over construction and operating risk, but pays more for private finance than it would for its own borrowing. So it is worth doing only when the value of the risk it transfers is bigger than that extra cost.
Key points
■Availability payments leave demand risk with the government; toll concessions move it to investors.
■In the worked example, transferring demand risk needs more than twice the equity and defaults at a 28.1% traffic shortfall.
■The UK NAO found PFI delivered more projects on time but at investor returns 2–4 points above government borrowing.
Decision rule
Give each risk to the party best able to control it. If neither party can influence usage, keep demand risk public and pay by availability; if the private party sets prices and service quality (a terminal, a parking concession), demand risk can go private. Accept a PPP only if it passes value for money with the extra financing cost counted. Ignore the rule where the government cannot credibly commit to pay for 25–30 years; then availability payments are only as good as its credit.
The costliest mistake
Pricing a demand-risk concession on hopeful traffic forecasts. Above, a 28.1% shortfall turns a 1.60× project into a default. In the real case, a consortium paid $3.8 billion in 2006 for a 75-year lease of the Indiana Toll Road; its concession company filed for Chapter 11 in September 2014 as traffic fell short (Indianapolis Business Journal). The state had been paid up front; the investors and lenders took the loss. Bid on a downside traffic case.
What the full article covers
In the full article I take you through these sections:
■2.6 Infrastructure Debt and Equity — Who Invests and Why
■2.7 Public-Private Partnerships (PPPs)
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Public-Private Partnerships (PPPs) and Infrastructure Finance, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance